21 - Debtors' Crisis or Creditors' Crisis? Who Pays for the European Sovereign and Subprime Mortgage Losses?

Summary

A Brief History of Sovereign Debt Resolution

The aftermath of the Latin American debt crisis was dominated by discussions of how to distribute the costs of the International Monetary Fund (IMF) and developed country financial support to insolvent government borrowers. Since US banks would have been technically insolvent had the losses on their lending to Latin American borrowers been recognized, it was impossible to suggest losses for the private lenders. Instead, the Federal Reserve adopted a policy of “forbearance,” which placed the onus on the borrowers to meet the full value of their loans.

One of the difficulties of distributing the costs of debt restructuring was reaching agreement among multiple creditors to new payment terms. The introduction of collective action clauses (CAC) into bond indentures was suggested as a means of facilitating qualified majority decisions to adopt debt restructuring. By the end of the 1990s virtually all new issues of sovereign bonds included such CACs.

The same issues of the appropriate division of losses from financial crisis resurfaced after the Asian crisis of 1997. To deal with such problems, in 2001 the IMF proposed a sovereign debt resolution mechanism (SDRM). Originally proposed by the United Nations Conference on Trade and Development on behalf of developing countries in the 1970s debt crisis, it was not adopted after the Asian crisis due to the objections of developing countries that it would be inappropriate for a protected creditor (the IMF) to be the agent operating the mechanism.